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Shorts Are Piling Into These Stocks. Should You Be Worried?

Do the shorts have these stocks correct, or are they blowing smoke? You be the judge!

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty of stocks that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% (nearly two-thirds) of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a damning factor to any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's take a look at three companies that have seen a rapid increase in the amount of shares currently sold short and see if traders are blowing smoke or if their worry could have some merit.

Company

Short Percentage Increase Since July 29

Short Shares as a Percentage of Float

Bank of New York Mellon(NYSE: BK)

55.6%

1.3%

Annaly Capital Management(NYSE: NLY)

15.1%

3.8%

STR Holdings(NYSE: STRI)

23.9%

24.1%

Source: The Wall Street Journal.

Fortune tellerNot every bank is worth tossing out with the bathwater just because Europe and a few select banks are having "technical difficulties." Bank of New York Mellon has been the exception to the rule with strong earnings results while other banks -- ahem, Bank of America(NYSE: BAC) -- struggle to produce.

In its most recent quarter, Bank of New York Mellon recorded a 15% jump in total revenue and a 9% GAAP earnings increase over the year-ago period. Two reasons the company cited for this growth were a 27% jump in investment service fees and a 14% jump in investment management fees. Perhaps even more important, Bank of New York Mellon is much better capitalized than many of its rivals, with a tier 1 capital ratio of 14.1%. With profits still streaming in, short-sellers may be running for cover sooner rather than later.

REIT-ten in the cardsIf I were personally in the mortgage REIT business, I would be sending the Federal Reserve a big thank-you card and perhaps a box of chocolates. Mortgage REITs, which make money on the spread between short-term and long-term interest rates, have been feasting on historically low federal funds levels. Because of the Fed's decision to keep rates near historic lows through mid-2013, it's likely that these companies will continue to benefit.

But when I see Annaly, Invesco Mortgage Capital(NYSE: IVR), and American Capital Agency(Nasdaq: AGNC) yielding 14.6%, 23.9%, and 19.7%, respectively, my initial impression is that this must be a value trap. In part, it is, because these yields will be unsustainable over the long term and spreads will eventually tighten. But given the Fed's stance on rates over the next two years, I think short-sellers are out of their minds to bet against such a high-yielding sector -- at least this early in the game.

Lights out, STRIf a stock's revenue is falling through the floor and no one is around to witness it, will the stock still fall? The answer is yes if you're an STR Holdings shareholder.

The provider of protective coatings for solar panels didn't just cut estimates for the third-quarter recently -- it nearly slashed them in half! Perhaps worse than the revenue guidance, the company sold off its quality assurance unit for $275 million in order to pay down debt. This means that with the solar industry suffering a rapid contraction, STR has decided to focus solely on its solar business.... D'oh! Even with drastically reduced earnings estimates, STR at 7.3 times forward earnings seems expensive relative to JA Solar Holdings(Nasdaq: JASO), a small-cap solar play I highlighted a few months back, at only 4.4 times forward earnings. As far as I can tell, the short-sellers own this stock.

Foolish roundupIt's important to remember that business trends matter. While it can be tough at times to ascertain which way a sector is trending, industry-wide earnings shortfalls in the solar sector or a surprise revenue jump in the banking sector can give you insight into whether short-sellers' opinions hold water.

Fool contributorSean Williamsowns shares of Bank of America, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLongThe Motley Fool owns shares of Bank of America and Annaly Capital Management. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policythat never needs to be sold short.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong